Guaranteed lifetime withdrawal benefit products: DB meets DC

Recent events and trends have thrust the topic of lifetime income products for retirement plans into the limelight. Retirements among the leading edge of Baby Boomers, medical advances increasing Americans' longevity, the market swoon of 2008 and continuing volatility in the financial markets have all contributed to a consensus that today's workers need options for their defined contribution plans that mimic the retirement income benefits of a defined benefit plan.

Earlier this year, the White House's Middle Class Task Force recommended initiatives to make it easier for Americans to save for retirement. This included promoting "the availability of guaranteed lifetime income products, which transform at least a portion of retirees' savings into guaranteed future income, reducing the risks that retirees will outlive their savings or that their living standards will be eroded by investment losses or inflation" (Annual Report of the White House Task Force on the Middle Class, February 2010).

Providing predictable retirement income while protecting participants from longevity and financial risks are core features of guaranteed lifetime withdrawal benefit products. A GLWB product meets the participants' desires for:

* retirement income they can't outlive

* the ability to capitalize on market increases but be protected from declines

* the assurance that their retirement benefit isn't affected if the market drops around the time they retire

A closer look

Advisers recognize the needs outlined by the White House task force. However, what's often not clear in the marketplace is how these products work.

So let's use Great-West's retirement income product, depicted in Figure 1, as an example. The solid black line is an example of a participant's fund value based on contributions and market performance. In this scenario, it generally rises until Year 7 during the accumulation phase. Then, the market drops - affecting the fund value - and rises again slightly just before the participant retires and takes a distribution in Year 10, beginning the drawdown phase.

The dotted line is the benefit base. It's established during the accumulation phase by additional contributions into the fund and by market performance when the fund value exceeds the benefit base on a ratchet date (depicted by the squares).

The ratchet date is the anniversary of the date the participant starts contributing to the product.

In this depiction, the benefit base, from which the retirement income is calculated over the life of the participant, remains the same even though the fund value declines during the drawdown phase, due to withdrawals and market fluctuations.

The bars represent the participant's guaranteed annual income, which continues even after the fund value drops to zero in Year 22.

The participant enjoys the upside benefit of market returns as well as downside protection. The benefit base remains stable as long as there are no excess withdrawals (amounts that are distributed or transferred from the fund during the accumulation phase or amounts distributed and transferred from the fund beyond the guaranteed annual income amount in the drawdown phase). The retirement income is guaranteed for the life of the participant and there is full access to any remaining fund value - even for elected beneficiaries upon the participant's death.

Flexibility and portability

Plan sponsors need a retirement income product to be flexible and portable, and to address their fiduciary responsibilities as well. Retirement income products specifically designed for the DC market fit this bill, offering a choice of investment options and providing participants with the ability to take their guaranteed income benefit with them when they change jobs or retire. In a GLWB product, participants may choose from a portfolio of lifetime asset allocation funds and a balanced portfolio (although the choice of investment options will vary from product to product).

As for portability, when participants separate service, many products on the market provide some type of participant-level portability, which enables them to convert their DC benefits into an IRA - and maintain the benefits. (An IRA GLWB product may not be available in every state.)

In addition, carriers in the industry have been working through The SPARK Institute to ensure mobility by developing standards for the exchange of information between recordkeepers and retirement income providers. These standards make it easier and more cost effective for recordkeepers and insurance carriers to make retirement income solutions available to plan participants. The standards allow customer-facing recordkeepers to offer one or more retirement income products from unaffiliated insurance carriers. The standards also facilitate portability of retirement income products when a plan sponsor changes recordkeepers.

Fiduciary issues

GLWB products also can help plan sponsors meet their fiduciary responsibilities. For example, in Great-West's retirement income product, participants are updated as to their benefit base and fund value on a regular basis and are educated on the product features, so there are no surprises. Participants are protected from market losses and are able to benefit from market gains. The underlying assets of the GLWB are invested in a mix of bond and equity investments that are selected in accordance with modern portfolio theory and monitored over time.

Investment classification

While the benefits of products designed for DC plans are clear, one of the challenges for plan sponsors is communicating the structure and investment options of the products. Through charts and accompanying descriptive material, plan sponsors can work with product providers to educate participants about the benefits and mechanics of GLWB products.

Another part of the process involves communication about the underlying investment options for the product. At Great-West, we have found that the retirement income product offering to participants is best facilitated through investment classifications that allow participants to best identify their goals.

Behavioral research has shown that participants fall into four investor types. About 50% are the "do-it-for-me" investors, who may not have the time, interest or knowledge to manage their retirement accounts. About 20% are the "help-me-do-it" investor. These individuals have a good idea how they plan to invest but prefer a little help. Another 20% are the "do-it-myself" investors, who are very involved in their retirement savings strategy. The remaining 10% are "no action" investors, or people who are indifferent to their retirement plans.

To avoid overwhelming or confusing participants, it's important to present investment solutions that speak the language of participants. Figure 2 (on page 19) shows investment options commonly found in DC plans. What appears to be a hodgepodge of options can overwhelm a potential investor.

An alternative is to organize and deliver investment options in a concise fashion by investor type, as shown in Figure 3 (p. 19).

Pay attention to compatibility

Not all retirement income products are designed to fit DC plans. Products designed for the individual market don't consider issues such as vesting or loans. Consequently, advisers should remind plan sponsors to review their plan documents and any retirement income product to ensure that they're compatible. Figure 4 highlights some factors to consider when adding a retirement income product to a plan.

GLWB fees

Finally, an important issue for your plan sponsor clients and participants is cost. Are these products worth the additional associated fees?

Volumes of academic, financial and behavioral finance research have been published about retirement income products. One study by Ibbotson Associates, Inc. (see "Allocation to Deferred Variable Annuities with GMWB for Life," Journal of Financial Planning, February 2010), addressed the question, "Does the higher equity allocation before and during the drawdown phase - along with longevity risk and other factors - create enough value to balance the added cost of retirement income products?"

For purposes of the study, Ibbotson assumed GLWB fees were 1.5% higher than the average mutual fund portfolio. This is much higher than most products in the DC space. Then it ran more than 5,000 sophisticated simulations.

The analysis by Ibbotson concluded that retirement income products:

* provide protection against market and longevity risks

* allow participants to have higher equity allocations before and during their drawdown phase

The study also concluded that, while retirement income products tend to cost a little more than traditional mutual funds, they also provide potentially higher annual income and total wealth.